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HMRC internal manual

Life Assurance Manual

Calculation of ‘I’ Income and chargeable gains: Derivatives not treated as loan relationships CTA09/Part 7: FA12/S74(1)(c)

The treatment of derivatives is set out in the Corporate Finance Manual at CFM 50000. Most derivatives, including those held by a life company will follow the treatment of loan relationships. There are some exceptions where these are subject to chargeable gains tax rules. In general this will be because the underlying assets are equities or property or as a result of specific anti-avoidance rules.

The provisions that tax certain derivatives other than as loan relationships, as set out in the Corporate Finance Manual, apply equally to life companies as to other companies. Where the specific conditions are met certain derivative contracts will be taxed using the chargeable gains rules. CFM 55000 onwards provides guidance on the CG aspects of derivatives. CFM 55010 contains a useful guide to the instructions on the CG aspects of derivatives.

CFM54020 summarises the special rules that apply to insurance companies.

Further detail on a number of the life specific provisions is set out below.

Simple derivatives held by a company carrying on long-term business: CTA09/S591

Life insurance companies may use for example, equity derivatives primarily in order to hedge a portfolio of equities. Since BLAGAB chargeable gains and losses on shares fall within the TCGA regime it is appropriate to keep derivatives which are hedging those shares within that same regime.

CTA09/S589 excludes from treatment as a derivative falling within Part 7 certain contracts, dependent on conditions (listed in CTA09/S591) and their subject matter. One such derivative (CTA09/S591(2)) is a simple derivative contract held by a life company.

Such a contract will be excluded by virtue of Condition A if it is a “plain vanilla” contract (i.e. one that is not an embedded derivative nor has another derivative embedded in it). The contract must be entered into or acquired by a company carrying on long-term business and the contract is an approved derivative for the purposes of INSPRU 3.2.5.   Generally this would include market traded derivatives held for efficient portfolio management and management of investment risk. Note that a derivative may be treated as held for the purpose of efficient portfolio management if the firm reasonably believes the derivative or quasi-derivative (either alone or together with any other covered transactions) enables the firm to achieve its investment objectives by, among other things, reducing tax (INSPRU 3.2.6).  That does not prevent the contract from falling within Condition A and so not being within Part 7.

This rule does not apply to any contract treated as a “quasi-derivative” for the purposes of the FCA Handbook.  This means that structured products, such as equity derivatives backing guaranteed income bonds and those designed to provide a guaranteed amount including prepaid equity derivatives with a floor or guaranteed equity bonds, are not excluded.

Note that changes in regulatory rules will potentially impact what is included in Condition A.

Embedded derivatives treated as meeting condition in CTA09/S591

CTA09/S592 identifies cases where an embedded derivative (which itself is treated under accounting standards as such) is to be treated as meeting the CTA09/S591 conditions. It applies where there is a ‘hybrid derivative’ (CTA09/S584) which, due to the size of the initial outlay, is not treated as a derivative but as a financial asset or liability, with the host contract also treated as a financial asset. The effect is to treat the embedded derivative as a chargeable asset and the host contract as a creditor relationship. This legislation aims to match the derivative tax treatment to that of the derivative contract’s underlying asset. See CFM52500 for further detail.

Derivative contracts embedded in loan relationships: chargeable gains treatment CTA09/S635

Convertible (including exchangeable) securities and asset-linked securities whose underlying subject matter is shares are sometimes held by life insurance companies.  They are analysed for accounting purposes as being in substance loans (creditor relationships) with embedded derivatives which provide the convertibility feature (an option) or the index or asset value-linked feature (a contract for differences).

A company that accounts for a creditor relationship at fair value through profit and loss would not, in general, bifurcate (i.e. split in two) into an embedded derivative and remaining loan relationship rights. To ensure there is no mismatch between the tax treatment of the derivative and the underlying subject matter of the derivative contract CTA09/S635 applies where there is a creditor relationship with an embedded derivative held for the purposes of BLAGAB. The tax treatment applying to bifurcated instruments is to apply whether or not fair value accounting (and so no accounting bifurcation) applies.

In relation to creditor relationships with embedded derivatives which meet certain conditions, chargeable gains treatment is given to the derivative element. See CFM55410 onwards for further information.